The Harrod-Domar model is a macroeconomic theory used to measure the economic growth of a country as a whole. Under this model, the growth of the economy is calculated as a factor of capital production and the individual savings rate. Economists rely on the Harrod-Domar theory as one method of estimating long-term economic growth rates. Combined with other models and theories, this calculation can provide valuable insight into the state of the economy, and may help politicians develop new policies to encourage growth.
This theory dates back to the 1930s, when British economist Sir Roy Harrod expanded upon earlier economic theories to develop this model. Harrod relied heavily on work by John Maynard Keynes, who is often considered one of the father's of economics. Harrod was both a close friend of Keynes and his biographer, as well as a prolific economist in his own right. Around the same time, Russian Evsey Domar came up with a similar model of economic growth on his own. The two joined forces to further develop what is now known as the Harrod-Domar model.
Under the Harrod-Dumar model, the growth rate of national income is equal to S divided by C. S represents the country's ratio of savings to income, while C represents the marginal capital output ratio. Capital output ratio is largely a measure of how productively businesses utilize capital equipment. All things being equal, the Harrod-Domar model postulates that the economic growth rate will always increase proportionally to the national savings rate. When savings rates decline, the national economy will grow at a slower pace, or even shrink over time.
This theory is based on the assumption that funding for capital investment comes with money that has been saved, rather than spent. By putting more money into savings accounts and other instruments, citizens make more money available for investors to borrow. With this borrowed money, companies expand operations, purchase new equipment or invest in new, more productive technologies.
Harrod and Domar assumed that production was fixed, and that current capital equipment could produce the same volume as future capital equipment. Later economists refined their theory into the exogenous growth model. This model differs from the Harrod-Domar model in that it realizes that each new generation of equipment should benefit from productivity increases due to technological advances.
Based on both the Harrod-Domar model and the exogenous growth theory, the most effective way to grow the economy is to increase savings rates. In theory, this means that politicians should set policies that spur savings in order to ensure economic growth. In practice, some argue that savings is largely dependent on income levels and income distribution. This means that it's very difficult to increase savings rates without major economic changes to increase or redistribute income.